A financial model for startups is a tool used to provide a numerical representation of a startup's strategy and vision. It communicates and forecasts the company's revenues, customers, key performance indicators (KPIs), expenses, employee headcount, and cash position.
Why is a Financial Model for Startups Important?
For early-stage startups, the financial model is a business plan that outlines the near-term expenses and goals for the company and illustrates the startup's growth potential in the long term. It can also be used as a budget for more sophisticated companies, informing different divisions within the organization of their projected hiring, major expenses, and financial goals. Companies raising venture capital funding use the projections as a tool to communicate with VCs, and it is often an important part of finance due diligence.
How to Create a Financial Model for Your Startup
To create a financial model, startups need to:
1. Determine the goal of the model.
2. Understand the KPIs for their company.
3. Get (or create) a financial model template.
4. Merge actual results into the template.
5. Start forecasting revenue.
6. Project headcount needed.
7. Estimate other expenses.
8. Model working capital.
To begin creating a financial model, it's important to first determine the goal of the model. This will help you decide how complicated it is to do the project. For example, if you are doing market sizing or making rough estimates, a less complicated model is better. However, if you are raising capital, you'll need to strike a balance between having enough detail to show that you understand the market, and not getting bogged down in minutiae. For a detailed cash flow model for an operating business, it is typical to have a very detailed analysis.
Next, it's important to determine the key performance indicators (KPIs) for your company. These KPIs should be numerical factors and assumptions that you can track and use to organize your key assumptions and outputs. Use industry standard KPIs as a starting point.
It's also a good idea to get a financial model template. Existing templates almost always make sense, and building a working piece of Excel from scratch can be time-consuming and a waste of time. Use one of the many free templates available online.
Once you have a template, merge your actual financial results into the projections. This will help you level set and ensure that there are no strange "kinks" in the model where actual results meet projections.
Start forecasting revenue by working your way down the income statement, starting with revenue. Make sure you understand what's driving revenue growth and think about the cost of goods sold as you project your revenue.
For most startups, headcount is the biggest expense, so it's important to project headcount needs and estimate the cost of each person, including recruiting costs.
Estimate other expenses by looking at examples from other successful companies and adding in additional expenses as the company grows.
Don't forget to model working capital, which can be a surprisingly large driver of your model's cash position. Understand when your clients will pay you and when you'll need to pay big vendors.
Best practices for forecasting for startups include building a three-year model that is dynamic, easily changing assumptions for each year, and including a waterfall throughout the entire sales funnel.
Review, Review, Review!
Entrepreneurs should review the financial model for their startup business for several reasons. Firstly, it helps them ensure that they have a clear understanding of their business's financial performance and outlook. By creating a financial model, they can better project their revenue and expenses, estimate profitability, and identify potential risks and opportunities.
Secondly, reviewing the financial model helps entrepreneurs identify potential flaws in their assumptions or data. By taking a critical look at the model, they can uncover any unrealistic or inaccurate assumptions, data, or projections that could lead to incorrect decision-making.
Thirdly, a financial model helps entrepreneurs communicate their business plans and financial projections to investors, lenders, or other stakeholders. It provides a clear and concise summary of the business's financial performance, allowing investors to evaluate the opportunity and make informed decisions.
Finally, a financial model helps entrepreneurs stay on track and adjust as needed. By regularly reviewing and updating the model, entrepreneurs can track their progress and adjust their strategies accordingly. This can help them make better-informed decisions and take corrective action, when necessary, ultimately increasing their chances of success.
Bottom Line
Ultimately, a well-designed financial model can help startups achieve their goals and become sustainable and profitable businesses. Therefore, it is highly recommended that startups invest time and effort in creating a solid financial model that accurately reflects their business's financial position and growth potential.